The Tax Trimmers

Like last year’s Trade Expansion Act, President Kennedy’s only consequential legislative proposal for 1962, the new tax bill, is a long, intricately detailed affair which—as is usually the case with tax measures—promises to be a lawyer’s delight and a layman’s labyrinth. The President has followed the precedent of the TEA in another respect, too. Just as last summer he mobilized well in advance of the Congressional season an extraordinary range of sentiment in support of a more liberal trade policy, so this year he has won the backing of a similarly broad coalition for the notion that tax reductions will serve the cause of economic growth, high employment, and unmarred prosperity. Here, however, the parallel ends, for while last year’s allies remained united through the passage of TEA, this year’s coalition—which comprises the Chamber of Commerce, the Committee for Economic Development, the AFL-CIO, and a large body of independent economic and editorial opinion (including that of Walter Lippmann)—is now quarreling not only about the distribution of the tax benefits, but also about the advisability of tying tax reforms to tax reductions.

The President’s total program of tax cuts and tax reforms involves, at least at first glance, some impressive numbers. At the completion of all the stages of the three-year sequence of reductions and reforms, gross reductions would total $13.6 billion and the reforms would recover some $3.2—3.3 billion for the Treasury, making the net reduction in the tax burden more than $10 billion, much the largest single diminution of tax liabilities in recent history. In 1965 corporations would surrender 47 per cent of their profits instead of the 52 per cent which they now pay, and levies on the first $25,000 of profit would drop from 30 to 22 per cent—a benefit to small companies. Individual income, now taxed at rates which rise from 20 to 91 per cent would enjoy a more humane progression from 14 to 65 per cent.

If all the reforms should be enacted, the bulk of the program’s benefits would go to earners of small income. However, the dramatic slash of top incremental rates would in all probability also do something to still the clamor over the adverse effects on incentives of present “confiscatory” rates. Moreover, since in real life very few people actually pay taxes at such rates, the Treasury would lose comparatively little revenue from the substitution of 65 per cent for 91 per cent as the highest marginal rate. Thus, though the President’s program marks no step forward toward greater equality of income distribution, it at least does offer something for all income groups.

If the President had stopped here, with the tax cuts alone, he might have had a proposal of almost universal appeal. But, possibly to his present sorrow, pressure within his own Administration and in Congress led him to put forward the complicated and controversial reforms as well. For if the tax cuts are to be taken as the major triumph of the Heller wing of the Administration, the reform aspect of the program can equally be taken as the major achievement of the Surrey-Dillon-Caplin school of thought at the Treasury, backed by Wilbur Mills, Chairman of the House Ways and Means Committee.

Whatever the merits of the proposed reforms and whatever the political considerations which argued for their submission to Congress at this time, there is no doubt at all that they have stirred up not one but a cluster of hornets’ nests—and the insects sting just as hard when they are in the wrong as when they are in the right. The reform which now seems most likely to fail is the proposal that taxpayers only be permitted to deduct for interest payments, medical expenses, and charitable contributions that exceed 5 per cent of their income. This provision afflicts most severely middle- and upper-income groups, for it diminishes the tax savings of homeowners burdened by heavy property taxes and mortgage payments.

It seems odd politics to affront home builders and home buyers and to be gentle at the same time with oil-wealthy Texans and Oklahomans who benefit so greatly from the mineral depletion allowances. But if the President has feared to make an all-out assault upon the oil interests, he has not hesitated to fight other battles. Thus the Treasury proposes to apply ordinary income-tax rates (instead of the 25 per cent capital gains tax) to the profits realized from the exercise of stock option rights by executives. Moreover, the dividend credit and exclusion—an Eisenhower benefit to the stockholder, under which the first fifty dollars of dividend income may be excluded from the taxable total—is to be terminated. Other changes are designed to curb some of the grosser tax benefits of oil-well ownership, limit the favorable depreciation treatment of real estate, tighten the rules which govern personal holding companies, and revise the treatment of capital gains. In general these alterations would increase Treasury receipts, and the 5 per cent deduction floor would provide the bulk of the added revenues. Certain other reforms, however, would cost the Treasury money. These include broadened income-averaging arrangements, more generous child-care allowances for working mothers, and slightly more favorable terms for the elderly.

For the most part these reforms are desirable. In many instances they are the culmination of years of agitation by tax attorneys and teachers of tax law. There is little doubt that their enactment would increase the equity of the tax system and move us closer to the democratic goal of equal treatment for individuals in identical situations. And it should be plain that the equity and efficiency gains of the reforms are considerably more important than the $3.2 or $3.3 billion of additional revenue which they would raise.

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Apart from this, it is the minor glory of the President’s approach that after hinting in his famous Yale speech and in press conference comment that a deficit should be planned as an instrument of national economic policy rather than deplored as a moral lapse on the part of thriftless politicians, he has at last expressed the idea in boldly concrete terms. Mr. Kennedy’s hopes for the impact of his policy are not small. He expects an increase in “total output and economic growth . . . by an amount several times as great as the tax cut itself,” reduced unemployment, stable prices, improvement in the balance of payments, higher standards of living, and expanded investment. And if Congress fails to rise to the occasion, then-, says the President, an even larger deficit will follow in the wake of sluggish economic activity, a renewed recession, and curtailed tax revenues.

It is to Mr. Kennedy’s credit as an educator that he should finally be trying to persuade Americans that the conduct of a nation is not comparable to the financial management of a household. But the educator has not dismissed the politician in the President’s calculations. His political arithmeticians have computed a deficit for the fiscal year 1964 of $11.9 billion—slightly below the record Eisenhower deficit of 1959—and they have with similar deference to political numerology, if not to economic sense, kept the Administrative or Conventional Budget just under $100 billion.

But this is not all Mr. Kennedy has done to lull the fears of the timid. He has offered a pledge, reaffirmed in Congressional testimony by his new director of the budget, Kermit Gordon, that public expenditures for non-defense programs will be held at or below present levels. And finally, he has uttered some soothing private enterprise noises. The loudest of these affirms that “a massive increase in Federal spending could also create jobs and growth—but in today’s setting, private consumers, employers, and investors should be given a full opportunity first.”

In short, the President intends to give a cautious whirl to Walter Heller’s pet argument that the American structure of progressive and corporate taxes impedes economic recovery. Heller’s case runs like this: During recoveries, personal income naturally rises, but because individual tax rates are progressive, larger and larger percentages of these increases are taken by the Internal Revenue Service. Of the parallel expansions in corporate profits, less than half remains at the disposal of the corporations that earn them. The consequences are a restriction of consumer and business spending, a tendency for tax receipts to increase more rapidly than economic recovery, and a probability that the Federal budget will approach first balance and then actual surplus well in advance of full recovery. As Heller sees recent history, the economy has behaved in much this way during recent recessions. If, as critics might take note, no surpluses have actually developed, this is because the “tax brake” choked off recovery too early for the full tendencies to work themselves out during the course of a whole fiscal year—the usual unit of record. “If,” says the President, “the tax brake on our economy is not released, the slack will remain, Federal revenues will lag, and budget deficits will persist.”

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So much for the program and its justifications. Is it an adequate program according to the Administration’s own lights? Is it the program which best answers the country’s economic needs? Will it really renew vigorous economic growth and reduce unemployment to the “interim” target of 4 per cent? So far as the remainder of 1963 is concerned, the prospects seem exceedingly poor that the tax program, even if it were to be passed according to the Administration’s schedule, would seriously influence economic activity. In fact, increases in social security levies and in state and local taxes are likely to collect more additional tax dollars than the federal reductions would release. Really noticeable benefits would not reach taxpayers until 1964, and the full effects of the program could not be realized until 1956. Whether circumstances will justify tax cuts then is anyone’s guess.

In sober truth more economists are willing to subscribe to the idea that a quick tax reduction would have an immediately stimulating effect than are eager to embrace the Heller-Kennedy doctrine that taxes are the root of all economic evil. Paul Samuelson, an Administration adviser and a supporter of the President’s tax program, nevertheless has confessed doubts. In a U.S. News and World Report interview (February 18, 1963), he observed that “the stifling effects of our tax system have been overplayed,” and added, “I do not think that tax reforms are going to do a great deal to improve the rate of progress.” As Samuelson and many others have noted, all the great expansions since the end of the Second World War occurred in the face of an even more burdensome tax system than the current one, while the recessions of 1958 and 1960 and the incomplete recoveries which followed each of them came after, not before, the Eisenhower tax reductions and reforms of 1954.

It should also be noticed that the Kennedy tax cuts promise in their present form to be effective agents of high economic growth only on the assumption that some extraordinarily chancy conditions are satisfied. The most important of these is that the economy will go on expanding at its present moderate rate—and the Economic Report of the President does in fact predict continued improvement during the whole of 1963. But as the Council of Economic Advisers observes, the present recovery will be thirty-four months old if it endures through December, 1963 (just one month short of the longest postwar expansion), and there is very little in the pace of the present advance or in the plans of government which bolsters the hope that expansion will break past records. The upshot is that if the upturn were actually to end in 1963, the Administration’s tax program would do literally nothing to stimulate economic activity at exactly the time when the need would have become most pressing. Last summer the evidence of impending recession was almost sufficient to persuade the President to request an immediate tax cut, unencumbered by tax reforms. It can scarcely be said that the economic picture is much brighter today than it was last July.

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Yet even if the cautious optimism of the Council of Economic Advisers turns out in the end to be justified, the state of the labor market and the changes taking place in the size of the labor force seriously diminish the efficacy of tax reductions as unemployment therapy. This year’s labor force is likely to be 1,200,000 larger than last year’s—an increase of perhaps 500,000 in excess of the year-to-year changes in the size of the labor force during the 1950’s. The Council of Economic Advisers’ own arithmetic implies that we shall be fortunate indeed if unemployment does not increase between now and next December. It is worth looking at the figures the Council gives.

To reduce unemployment from its present 5.6—5.8 range, the economy must create 1.1 million new jobs;

If business improves, and the prospect of finding jobs once again becomes real, another 800,000 men and women will return to the labor market;

An additional 1,200,000 jobs will be needed for the newcomers to the labor force;

Although the Council oddly omits a numerical estimate, a substantial number of jobs will also be needed to accommodate factory and office workers being displaced by technological change.

Even without the inclusion of the fourth category, 3.1 million new jobs are needed to bring the economy within sight of the 4 per cent unemployment target—and the target itself is unsatisfactory. What is called for, then, is a 4.7 per cent expansion of employment. Yet job expansion actually reached this figure only in the boom year of 1955.

From all this it seems plain that the President has tacitly written 1963 off. The staging of the tax cuts, the willingness to combine reform and reduction, and the caution of the Administration’s economic forecasts for this year, point to 1964 and 1965 as the testing years. Though Kennedy supporters may well squirm at the sight of a liberal President’s willingness to live during the third consecutive year of his term of office with high rates of unemployment, an economic boom in 1964 and 1965 would do much to ease their pain.

What about 1964 and 1965? Applying the simplest and most primitive of Keynesian doctrines—which discerns in deficient aggregate demand the source of business debility—the Administration program in effect (if not in statement) rests its 1964 and 1965 hopes on its capacity to stimulate spending. Military and space programs will add some $4.5 billion to federal spending, while the tax reductions are designed to encourage both personal consumption and business investment, the second and third components of the aggregate demand for goods and services. If consumers cooperate by spending the bulk of their tax savings, and if investors feel more buoyant because their corporations can retain more of the proceeds of investment and they themselves can keep larger portions of dividend income, the increase in national income will amount to some multiple of the tax reduction. In time increased consumer spending will strain existing plant facilities and further investment will be necessary for capacity expansion: this is the economist’s “acceleration” process. Guesses about the values of the multiplier and the accelerator have more to do with the psychological condition of the guesser than with anyone’s ability to estimate future consumer and investor behavior. The favorite current guess, however, is that a $10 billion net reduction in taxes should, through the combined effects of the multiplier and the accelerator, increase Gross National Product by about $30 billion, or a factor of 3.

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Is this enough stimulation to get the economy moving and to bring unemployment down to 4 per cent? The Economic Report of the President estimates that we have at the moment sufficient unused capacity to produce between $30 billion and $40 billion of additional goods and services. Other students of the problem advance much larger numbers—as high as $70 billion. Now, if the $10 billion tax cuts were made available immediately, if the lower of the estimates as to unused capacity were accepted, and if the combined value of the multiplier and the accelerator really turned out to be 3, then this tax cut could probably eliminate most of our currently unused capacity, although it would still not fully meet the Administration’s employment goal. But: the $10 billion tax cut will not be realized until 1965, and by then, even at current rates of investment, industrial capacity will be much larger and the labor force will comprise at least an additional 2.5 million workers. In default of a sudden leap in economic growth, therefore, the President’s program is simply too small to accomplish its aims. It would seem that there is considerable accuracy in Leon Keyserling’s charge that the Administration has sent a “pygmy to do a giant’s job.”

In 1964 and 1965, when the tax program builds to its climax, it will appear either irrelevant or inadequate. In the unlikely event of a genuine boom, tax reductions will not be needed to enlarge demand. Indeed they might have the undesired effect of increasing inflationary pressure and endangering the balance of payments. If, as is much more likely, 1964 and 1965 are recession years, then the amounts to be released are simply much too small seriously to mitigate a recession.

There is something to be said for a rapid reduction of taxes once and for all in 1963 and the simultaneous jettisoning of the tax reforms. Such seems to be the present mood of the Committee for Economic Development and the AFL-CIO.1 There is, however, almost nothing to be said for a tax reduction largely postponed until 1964 and 1965. Hence the President’s program seems little more promising as a long-run measure than it does as a 1963 attack upon economic sluggishness. This is a pity: much would be gained from a successful peacetime experiment with Keynesian tools. At the least, public sophistication in modern economics would be enormously enhanced. As it is, a good Keynesian might well prefer no experiment to an experiment doomed to failure because of excessive timidity on the part of the experimenter.

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What has been said so far is designed to demonstrate the inadequacy of the Kennedy tax program as an exercise in fiscal policy. But even a better fiscal policy would not suffice to meet the economy’s basic difficulties, for these difficulties belong only in part under the rubric of deficient aggregate demand. The ailments of our economy in increasing measure are structural, not fiscal. They have to do with the matching of people and skills; technological displacement of workers; inadequate education; inequitable distribution of income; urban poverty; and the allocation of national resources between the public and private sectors. The symptoms are not unknown. Take, for example, technological displacement. The argument is probably fruitless whether or not automation really amounts to a qualitative departure from the incremental changes in technology which have become more or less routine since the Industrial Revolution began. Whoever is right on this point, the facts are sufficiently grim. Solomon Fabricant of the National Bureau of Economic Research has estimated that between 1889 and 1953 physical output per man hour increased in the United States at an average annual rate of 2.3 per cent. In other words, in 1961 it was possible to produce 1960’s Gross National Product with 1.5 million fewer workers. Thus if productivity increases simply at its historic rate in the coming years, at least 1.5 million workers will be displaced annually. Here is one possible figure to fill in the blank left in the Council of Economic Advisers’ fourth category of job needs cited above.

No doubt a buoyant economy can soften the impact of such displacements, but ours has not been a buoyant economy. Rather it has been an economy which during the last five years has had average unemployment rates of 6 per cent. Not only that, but between 1948 and 1958 the average duration of unemployment rose from 10.3 to 14.3 weeks. In consequence, between 1958 and 1962 the country probably lost at least $170 billion of goods and services which might have been produced by available manpower and factories.

Much of this problem of unused human labor and talent is a problem of the cities. School drop-out rates are disconcerting, and vocational education has not adjusted to changing technical needs, all too frequently becoming a dumping ground for the backward and the delinquent. After a generation of gestures to public housing and urban redevelopment, slums still disfigure every sizable American city.

Almost unnoticed in our split-level economy, poverty has become a permanent condition for a very large slice of the urban population. As Herman Miller demonstrated in a striking article in the New York Times Magazine (November 11, 1962), literally nothing of consequence has happened to the distribution of income in the United States since 1944 except a moderate improvement in the position of the second richest fifth of income recipients. In 1944 the worst-paid fifth of the population received 5 per cent of the national income, and they are still stuck at this share. The top fifth, which enjoyed over 45 per cent of the national income in 1944, has maintained its position. Even in the 1960’s, to be in the bottom fifth of the income distribution is to be poor in the old-fashioned sense of the word. Individuals in that category in 1960 earned on the average less than $2,800 annually, about $55 a week, a trifle over the national minimum wage level. Moreover, in the last decade the gap between the earnings of whites and Negroes, once thought to be narrowing, has changed not at all. At the beginning of the 1950’s non-whites earned about three-fifths as much as whites; they are no better off today. Thus, the “revolution” in income distribution of which economists used to write has long since ground to a halt.

The situation of the poor is the consequence of a double failure. For one thing, market forces have not been strong enough to draw the unskilled and the ill-educated into the labor force—whereas in times of really high prosperity industry itself assumes a good deal of the burden of training workers who initially lack the skills or fall short of the standards which employers consider desirable. The second failure is public. It is a failure really to enforce anti-discrimination policies in employment, residential desegregation in housing, and racial desegregation in urban schools. It is a failure to grapple with the uncomfortable fact that the unskilled and the ill-educated stand diminishing prospects of employment. It is a failure, finally, to take the city into account. If we are not to maintain a large proportion of our urban population in angry idleness, we must do something substantial with vocational training of the young, retraining of mature workers, education in general, urban redevelopment, minority housing, and social welfare. The domestic peace corps is a gesture of good will, but it by no means constitutes a determined assault on our complex social and economic problems.

The real inadequacy of the President’s tax emphasis is revealed in these needs. It may well be that our cumbersome Congress is capable of handling only one major legislative program a year, and indeed, the Administration’s strategy appears to accept this limitation as a fact of life. In 1963, then, the Kennedy Administration has traded for a timid tax program its chance to make a concerted attack upon the problems of the cities in which most Americans live.

A serious program of this nature, however, requires substantial increases in public expenditures rather than tax reductions. It implies liberal financing of schools, hospitals, houses, recreation, and social agencies. The diagnosis of the poverty of the public sector of the economy offered by Galbraith in 1958 in The Affluent Society is no less pertinent to 1963. Resources must still be shifted from the private to the public sector. To deliberately encourage consumer purchases of automobiles, electrical appliances, and leisure articles at a time of serious public need involves a species of social insanity, and yet this is precisely what a tax cut does. Even if such a cut succeeded in stimulating aggregate demand, it would do very little to increase the production of the goods and the services which are most needed, those which add to the social investment of the public sector.

It is sometimes forgotten that there were always two Keyneses; and as a society we may be somewhat belatedly listening to the wrong one. There was the Keynes who saw nothing more grievously wrong with contemporary capitalism than inadequate aggregate demand and who contemplated no remedies more disrupting than alterations in interest rates, the supply of money, and the size of government deficits. But there was also the Keynes of The Economic Consequences of the Peace and Chapter 24 of The General Theory of Employment, Interest and Money. This Keynes toyed with the euthanasia of rentiers, speculated about the possibility of a long-run decline in the rates of profits to be expected in rich countries, questioned extreme disparities of income and wealth, and wondered whether a “somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.” The Administration’s Keynes is the mild chap of the first version. But if we are to cope successfully with the problems of the 1960’s, we shall have to begin paying much closer attention to what the second Keynes had to say.

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Footnotes

1 Indeed the President's own comments at the now famous February symposium of the American Banking Association gave powerful support to the tax cut now, tax reform later school of thought.